Separation of wholesale/retail operations will only serve to decrease investments in broadband infrastructures

G. CONCLUSION

EXECUTIVE SUMMARY

In the context of what began as a voluntary "global" settlement negotiation to resolve a number of outstanding independent telecommunications regulatory proceedings, the Pennsylvania Public Utility Commission ordered that Bell Atlantic-Pennsylvania establish separate corporate entities for its "wholesale" and "retail" local exchange operations. Apart from the chilling effects on future settlement negotiations which may result from the process used by the commission in this instance, the decision to require a breakup of Bell Atlantic’s wholesale and retail operations is unsound as a matter of policy and should be reversed.

In order to facilitate the transition to a competitive telecommunications environment, particularly one in which broadband services become widely available, regulators should impose on the incumbent telephone companies only the least costly regulatory requirements consistent with pro-competitive objectives. And, as importantly, regulators must not impose regulatory obligations on the incumbents which, in effect, remove the incentives for competitors to build-out their own facilities.

For true competition will not develop, or be sustained, if competitors can obtain every network component they wish at regulatory-controlled prices, even when such components in no way remain "essential facilities." In other words, the incumbent should not be required to make available to competitors inputs at regulatory-controlled prices unless the competitors have no feasible alternatives because such inputs are natural monopolies. As Justice Stephen Breyer said in his concurrence in the AT&T v. Iowa Utilities Board case, "[a] totally unbundled world…is a world in which competitors would not have anything left to compete about."

Specifically, the commission’s requirement for a wholesale/retail breakup is unwise for the following reasons:

At this time in the transition to a competitive environment, the costs of the imposition of a novel form of structural separation far outweigh the benefits. In the Competitive Safeguards proceeding in 1996, the Pennsylvania commission found, after weighing the costs and benefits, that non-structural safeguards were sufficient to protect competitors from access discrimination and cross-subsidization concerns. It determined then that if it ordered structural separation, Bell Atlantic unnecessarily "would have been deprived of the economies of scale and scope that commonly characterize a unified telecommunications enterprise." With the further safeguards which are now in place as a result of the passage of the Telecommunications Act of 1996 and the Pennsylvania commission’s own actions, there is even less justification today than there may have been three and a half years ago to impose more costly structural safeguards. While we have not attempted independently to verify Bell Atlantic’s claim that it will incur expenditures in the range of $1 billion to implement the PUC’s breakup order, there is no doubt that the costs indeed would be very substantial.

The unique form of separation imposed by the Pennsylvania commission necessarily is based on the backwards-looking assumption that the incumbent’s local exchange network will remain a monopoly and, therefore, will need to be subject to traditional regulatory oversight for the indefinite future. Hence, the commission says that "[w]hen true competition develops, BA-PA’s retail operations will no longer require a heightened degree of oversight." In other words, the PUC envisions competition developing – and regulatory controls being reduced – only at the retail level. This is contrary to the goal of the 1996 Telecommunications Act that facilities-based competition develop for local services. (Somewhat curiously, at the same time that the commission contemplates continued regulatory oversight of Bell’s wholesale operations into the indefinite future, it says it anticipates that the local exchange will be irreversibly open to competition within approximately one year.)

The wholesale/retail structural split is broader than the separate subsidiary requirement contained in the 1996 Telecommunications Act and that apparently authorized by the Pennsylvania code. The 1996 Act requires structural separation, subject to sunset requirements, for some of the Bell Companies’ non-local exchange "competitive" services, such as information services and long distance. It specifically contemplates that the incumbents will continue to offer wholesale and retail local exchange services through the same entity. And the Pennsylvania statute specifies that the PUC may only authorize structural separation for services it designates as "competitive." In this case, the commission has done no such thing.

Bell Atlantic’s competitors, such as MCI, Sprint (perhaps to be one MCI/ Sprint) and AT&T/TCI have very strong positions in the long distance market and have entered the local marketplace with substantial resources. At the time Bell Atlantic-PA is allowed to enter the long distance market, it will have no market share. It is unfair – and ultimately harmful to consumers – for regulators to impose the substantial extra costs and inefficiencies on the incumbent alone if less costly regulatory alternatives will protect competition. Regulators have an obligation not to increase the incumbent’s costs unnecessarily.

Asymmetrical regulation such as that proposed by the Pennsylvania commission particularly will discourage the large investment by the incumbent telephone companies necessary for the transition from a narrowband infrastructure to one supporting a wide array of high-speed integrated voice, data, and video digital services.

There are other aspects of the commission’s order that might be questioned as well, such as whether a new "tax" needs to be imposed on carriers (which they are ordered not to recover from their customers) to establish a new Consumer Education Fund. The fund will expend money educating consumers "about their new choices" in the local exchange marketplace so they will not be confused by "a very dynamic environment."

Whatever else one may think of the wisdom of this type of new program supported by a new mandatory tax on carriers, the fact that the commission believes it necessary belies the notion that the local exchange marketplace is not likely to become competitive in the near-term. In and of itself, the Commission’s recognition that we are all faced with a dynamic new local telecommunications environment should cause it to reconsider the imposition of a novel form of structural separation which assumes just the opposite.

A. INTRODUCTION

The promise of unfettered competition and meaningful deregulation, so widely and loudly heralded when President Clinton signed the Telecommunications Act of 19961, has turned into what some have called a "regulatory Vietnam," a quagmire in which every step towards deregulation is matched by a step backwards. Many of the Federal Communications Commission’s recent actions illustrate this phenomenon of imposing more detailed and cumbersome regulatory requirements on the incumbent local telephone companies ("ILECs"), including on their provision of new broadband services. This is so even at the same time the Commission acknowledges the opportunity costs imposed by unnecessary regulation with regard to the ILECs’ competitors.

For example, FCC Chairman Kennard recently spoke eloquently about the costs of regulation in explaining why the Commission has refused to require cable television operators to provide unaffiliated ISPs such as AOL nondiscriminatory access to their cable modem service:

"It is easy to say that government should write a regulation, to say that as a broad statement of principle that a cable operator shall not discriminate against unaffiliated Internet service providers on the cable platform. It is quite another to write that rule, to make it real and then to enforce it. You have to define what discrimination means. You have to define the terms and conditions of access. You have issues of pricing that inevitably get drawn into these issues of nondiscrimination. You have to coalesce around a pricing model that makes sense so you can ensure nondiscrimination. And then once you write all these rules you have to have a means to enforce them in an meaningful way."2

Chairman Kennard continued, knowingly, "I have been there on the telephone side," and it would be wrong to "just pick up this whole morass of [telephone] regulation and dump it wholesale on the cable pipe.3

At the same time the Commission is refusing – correctly – to regulate the cable industry’s modem service, it issues ever more intricate orders setting forth ever more detailed requirements that the ILECs must follow in unbundling and sharing their networks.4 The latest requirement mandates that the ILECs share the bandwidth capacity in their local loops.5 Not only is the Commission imposing myriad unbundling, interconnection, and resale requirements, but it also exercises close regulatory oversight with regard to the pricing of the services that it requires to be made available to competitors pursuant to these access mandates.

Unfortunately, some states are taking actions that are more unsound than those of the FCC in regulating the ILECs. A recent order of the Pennsylvania Public Utility Commission ("the PUC" or "Commission") falls into this category.6 If it is not modified, it will have the effect of inhibiting the further development of local and long distance competition in Pennsylvania and stifling the incentives to invest that are necessary to the build-out of competing modern telecommunications infrastructures, particularly the upgrade of infrastructures supporting the transition to widespread delivery of broadband services.7 And, if not modified, the Pennsylvania action also may establish a precedent which, however unsound, other regulators may be tempted to follow.

B. A "VOLUNTARY" SETTLEMENT PROCEEDING GONE AWRY

In the context of a so-called voluntary "global settlement" proceeding initiated in an effort to resolve a number of outstanding telecommunications regulatory proceedings, the Pennsylvania PUC proposed in a September 30, 1999 order that Bell Atlantic-Pennsylvania, Inc. be broken up into two separate companies for purposes of offering local exchange services. One entity would offer only "wholesale" services and the separate corporate entity would offer only "retail" services.8 This proposal by the Pennsylvania commission is noteworthy because it appears to assume – wrongly – that the incumbent telephone company’s local exchange network infrastructure will not become subject to effective competition and, therefore, for the foreseeable future, that the incumbent’s local exchange facilities must be subject to continued heavy regulatory oversight.

If the Pennsylvania commission’s views concerning structural separation along "wholesale/retail" lines were to gain sway with other state regulators, or with the FCC, consumers of telecommunications services throughout the nation would be harmed. The incumbent local carriers’ incentives to invest in network modernization efforts would be reduced and the continued development of sustainable local and long distance competition would be undermined. Additionally, reduced incentives for network upgrades will limit the ability of the incumbent telephone companies to participate in the broadband revolution and will deprive consumers the benefits of having of competitive providers of broadband services, such as high speed data and digital video.

At the same time that it ordered this unique form of structural separation9, the Pennsylvania PUC required BA to reduce its intrastate access charges, reduce the rates for interconnection and unbundled network element services, enhance collocation opportunities for new entrants, extend the rate caps for certain of its own local exchange services beyond the previously-agreed upon expiration date, and embark on other new programs. For example, the commission required BA to fund, along with other carriers, a Consumer Education Fund to engage in efforts to educate consumers "about their new choices" in the local exchange marketplace so that they will not be confused by "a very dynamic environment."10

There are several aspects of the PUC’s September 30 decision that might be questioned in and of themselves, such as whether the required reductions in the prices for UNEs are cost-justified or whether the new interconnection and unbundling requirements are reasonable or whether the new Consumer Education Fund represents sound policy. (It is worthwhile observing at this point that the impetus behind the establishment of the new fund is a recognition that consumers will be confronted with new choices in the local marketplace. It is questionable whether another new "tax" needs to be extracted from the telephone companies to fund various select individuals and groups to "educate" consumers about their new telecommunications alternatives. The competitors will have every incentive to perform this function. In any event, the acknowledgment that consumers will face new choices in a dynamic marketplace undermines the fundamental premise of the structural separation requirement—that the local exchange is likely to remain a natural monopoly.)

Any "settlement" process involves some "give and take." Certainly there are benefits from a public policy viewpoint in reaching a fair and comprehensive settlement of the outstanding issues before a regulatory body because such a settlement allows the contending parties to know with a greater degree of certainty what the shape of the regulatory landscape will be. Thus, it is to be expected that individual pieces of the total package, standing alone, might not be the preferred outcome from a public policy perspective.

In this instance, however, the Pennsylvania PUC’s decision to require separate corporate entities for the carrier’s "wholesale" and "retail" local exchange operations is sufficiently problematic that it is worthy of highlighting on its own merits. Because the structural separation requirement mandated by the PUC is the feature of the Commission’s decision that, on a forward-looking basis, is most out of step with the realities of today’s telecommunications environment, this paper will focus principally on that requirement.11

C. IN TODAY’S TRANSITION TO A COMPETITIVE ENVIRONMENT, THE COSTS OF IMPOSING A NOVEL FORM OF STRUCTURAL SEPARATION OUTWEIGH THE BENEFITS

The fundamental purpose of both structural and non-structural safeguards in the context of regulation of incumbent local exchange carriers is to prevent the ILECs from using their present dominant market position to favor their own unregulated affiliates over their competitors and to prevent them from cross-subsidizing more competitive services with revenues from less competitive services. But the transactional costs imposed by structural separation are even greater than those imposed by non-structural safeguards, which, of course, are substantial in any event.12 In an increasingly competitive environment, any increase in the costs imposed by unnecessary regulation unfairly benefits the competitors, not competition.

As Alfred Kahn, one of the country’s foremost experts on regulatory economics, puts it:

The reasons businesses conduct a number of operations under the umbrella of a single financially affiliated entity, rather than through market transactions, is, in a fundamental sense, the belief that subjection of these several operations to unitary managerial control permits the achievement of savings of transaction costs, as well as avoiding the uncertainties of trying to achieve the requisite purchase and coordination by purchases and sales in the market. In these circumstances, the very notion of requiring a firm to share those economies ‘equally’ with outsiders contradicts the very notion of a firm.13

Prior to the implementation of policies at the federal and state level designed to foster competition in the local exchange marketplace – and the emergence of actual competition as a result of these policies – the imposition of some form of structural separation may have made more sense.14 Even though structural separation imposes substantially greater costs on the incumbent than reliance on non-structural safeguards in terms of the required duplication of facilities, personnel, and systems,15 if the prospects for the development of competition in the heretofore non-competitive market are sufficiently bleak because it is thought to be a natural monopoly, it is easier perhaps to justify such greater costs under some type of cost/benefit analysis.

The Pennsylvania PUC itself previously has recognized that structural separation imposes greater costs than nonstructural safeguards. In 1996, when the emergence of local competition was in a much earlier stage of development than today, the commission refused to impose a separate subsidiary requirement with regard to Bell of Pennsylvania’s offering of competitive services.16 In the Competitive Safeguards proceeding, the commission found, after weighing the costs and benefits, that non-structural safeguards were sufficient to protect competitors from access discrimination and cross-subsidization concerns. It pointed out that if it ordered structural separation, Bell unnecessarily "would have been deprived of the economies of scale and scope that commonly characterize a unified telecommunications enterprise."17 The competitive separate subsidiary "would have had to absorb the full range of joint and common costs that otherwise share within the boundaries of the unified service operation, with a direct and consequent effect on the prices of the associated competitive services."18

Now, however, over three and one half years later, the PUC proposes to require the incumbent telephone company to initiate a process to place its "wholesale" and "retail" operations into separate corporate entities. This proposal is unsound and backwards-looking because it assumes that there will not be competing alternatives to the ILECs’ basic network infrastructure and that, therefore, regulators will continue to regulate the "wholesale" infrastructure indefinitely. Hence, the Pennsylvania commission says that "[w]hen true competition develops, BA-PA’s retail operations will no longer require a heightened degree of oversight."19 In other words, the PUC envisions competition developing – and regulatory controls ultimately being reduced – only at the retail level and only for the retail entity.

But policy frameworks are now in place at the federal level, as a result of the passage of the Telecommunications Act of 1996, and at the state level, as a result of the various state commissions’ decisions, that are fostering competition in the local exchange marketplace. The interconnection, unbundling, and resale requirements applicable to the ILECs – in other words, the imposing array of non-structural safeguards guaranteeing that ILEC competitors will have cost-based access to the ILEC’s own network infrastructure and will not be disfavored vis-à-vis the incumbent’s own service offerings 20– ensure that the local exchange marketplace is in the process of being opened to competition. (This assumes that these requirements are not carried so far that they remove all incentives for the ILECs’ competitors to build-out their own facilities infrastructure.)

In fact, in New York, Pennsylvania’s neighbor, the Public Service Commission already has determined that the local exchange marketplace is open to competition.21 There are differences in each state, of course, but it is unlikely that the conditions in New York and Pennsylvania are so different that the Pennsylvania commission would assume that local competition on a facilities basis will never develop. Indeed, Bell Atlantic apparently has made at least some progress in Pennsylvania because the PUC says that it anticipates that BA can obtain "Section 271 approval" from the FCC to offer interLATA services within approximately one year.22 As the PUC acknowledges, in order to recommend such approval to the FCC, the Department of Justice must conclude that the local market is "irreversibly open to competition" and the FCC must find that BA has satisfied the TA’s "14-point competitive checklist."23

The PUC also states that it does not anticipate it can complete a follow-on proceeding necessary to develop a structural separation plan before the FCC is ready to grant Bell Atlantic’s request for Section 271 approval.24 Thus, the PUC proposes to implement a novel form of structural separation at the very time that the pro-competitive measures required by the 1996 Act and by the PUC itself will have succeeded in "irreversibly" opening the local exchange to competition.25

In fact, the PUC may be unduly optimistic that it can complete the structural separation implementation proceeding within a one-year time frame. The proceeding commences with the requirement that Bell file a plan "of sufficient detail to identify each component or element of retail service needed to be structurally separate and to allow a current and verifiable cost analysis of each component or element, and to provide the Commission with such cost analysis."26 In other words, the proceeding will not only involve disputes among the interested parties concerning the delineation of the individual "components" or "elements" of services to be placed in the separate entities, but it almost certainly will turn into a full-blown rate proceeding regarding these components and elements, with contending cost-of-service witnesses.27

Whatever the merits a structural separation approach may have had in the past, it is counter-productive at this time for regulators to impose such a remedy, especially in the form of a wholesale/retail split that assumes that the local exchange will remain non-competitive. Compliance with the non-structural safeguards and the more limited form of separate subsidiary requirements of the 1996 Act will accomplish the Commission’s pro-competitive objectives.

D. A "WHOLESALE/RETAIL" STRUCTURAL SEPARATION IS INHERENTLY UNSOUND AND BROADER THAN THAT REQUIRED BY THE 1996 TELECOMMUNICATIONS ACT

It is true that the 1996 Telecommunications Act requires separate subsidiaries – subject to varying sunset requirements28 – for some of the BOC’s non-local exchange "competitive" services, such as information services and long-distance. But the Telecommunications Act does not require a structural separation of the incumbents’ local exchange facilities on a "wholesale" and "retail" basis. Indeed, it contemplates exactly the opposite: that the incumbent will continue to offer wholesale and retail services through the same entity. Thus, Section 251(c)(4) provides that ILECs have a duty "to offer at wholesale rates any telecommunications service that the carrier provides at retail to subscribers who are not telecommunications carriers."29

While the Pennsylvania statute authorizes the PUC to order structural separation, it specifies that it may do so only for "competitive services."30 This demarcation between competitive and non-competitive services in the Telecommunications Act and the Pennsylvania statute – dependent on an identification of specific services as "competitive" – is a more limited and workable form of structural separation than a regime that attempts to implement separation of all "wholesale" and "retail" local exchange operations.

Most fundamentally, apart from the practical difficulties associated with implementation of a wholesale/retail dichotomy,31 this type of novel structural separation is unsound policy. It is based on the assumption that the incumbents’ local network infrastructure will remain a "bottleneck" facility for the indefinite future, subject to traditional regulatory controls, including rate regulation. As discussed above, this premise is incorrect, except to the extent it becomes a self-fulfilling prophecy by virtue of imposition of ill-conceived regulatory schemes.

By signaling that traditional rate regulation and other close regulatory oversight of the incumbents’ basic local exchange network infrastructure will remain in place indefinitely, regulators will reduce the incentives of the incumbents to upgrade their own facilities in the hope of gaining a competitive edge. And they simultaneously will reduce the incentives of competitors to build out their own infrastructures. The action of the Pennsylvania commission will "in a very real sense discourage competition itself, in the name of encouraging it: if competitors can obtain from incumbents, at regulatory-prescribed prices, not just facilities and services that are naturally monopolistic but any and all others – present and future – that could feasibly be supplied independently, the incentive of incumbents to innovate and of competitors to provide their own will be attenuated."32

Moreover, there are some local exchange services that the Commission would require incumbents to "wholesale" to their CLEC competitors that already are or will become competitive (for example, interoffice trunks and switching facilities) more quickly than others (for example, local loops). But, conceptually, the "wholesale/retail" split doesn’t distinguish among specific elements of local exchange services based upon the degree of competitiveness of the service, or even the near-term likelihood of a change in the competitive status. That’s almost certainly why the 1996 Telecommunications Act assumes that BOCs will continue to offer "wholesale" and "retail" services through the same corporate entity,33 and why the Pennsylvania statute grants the PUC the authority only to require that services it designates as competitive be provided through a separate subsidiary. In contrast, the approach taken by the PUC essentially assumes, on a static basis, that any element or component of local service which a competitor wishes to acquire from Bell must remain subject to indefinite regulation.

Under the Pennsylvania commission’s proposal, Bell Atlantic alone would be required to incur the extra costs and inefficiencies imposed by structural separation. This is so even though companies like MCI and Sprint (perhaps to be MCI/Sprint) and AT&T/TCI have very strong positions in the long distance market and have already entered the local exchange marketplace with substantial resources. Recall that at the time when the separation of BA’s operations is to be implemented – no earlier than a year from now – these major Bell Atlantic competitors and others (for example SBC) presumably will be able to compete in the local exchange marketplace because the PUC predicts that the local market will be irreversibly opened to competition.

But also note that at that time BA will have no presence in the long distance marketplace because it will just be at the starting gate. Of course, if Bell of Pennsylvania has not opened up its local exchange in accordance with the 1996 Act’s requirements and the Pennsylvania commission’s requirements, then presumably the PUC would not recommend, and the FCC would not grant, Bell’s Section 271 application, and we are not here suggesting otherwise.

At a time when all service providers acknowledge that consumers are looking for one-stop shopping to satisfy their various communications needs and providers are rushing to respond by offering a cost-efficient bundled package of services,34 it is inappropriate to require that the incumbent alone be handicapped by requiring it to offer its services through separate corporate entities. And it is inappropriate to impose the substantial extra costs and inefficiencies of structural separation in terms of duplication of facilities, personnel, and systems on the incumbent alone if less costly alternatives will protect competition.

The solution, of course, is not to impose structural separation – or even non-structural safeguards – on the ILECs’ major competitors for the sake of achieving regulatory symmetry. The appropriate course is for regulators to choose the least-costly regulatory alternative for the ILECs that will accomplish the pro-competitive objectives.

When the Pennsylvania legislature enacted new Chapter 30 of the Public Utility Code in 1993, a principal purpose was to provide a regulatory regime that would encourage the accelerated deployment of broadband facilities which will enable transmission of high-speed, high–capacity services encompassing data, voice, graphics, and video communications.35 The Telecommunications Act of 1996 had the same goal, of course.36

Proposals such as the Pennsylvania commission’s, apart from all of the reasons discussed above, are especially unsound with regard to the inhibiting effects they are likely to have on the deployment of ILEC broadband services.37 Competitive safeguards which treat incumbents so differentially vis-à-vis their competitors will discourage ILECs from investing in the facilities necessary to lead to widespread deployment of broadband services envisioned by the 1996 Act and the Pennsylvania legislature. An examination of such disparate treatment in the context of the competition between cable operators and incumbent telephone companies to offer broadband services, including Internet access services over their own infrastructures, illustrates this point. It should be noted, however, despite the focus here on the cable/ILEC rivalry, that the competition to deliver broadband services extends to several other delivery modes.38

Cable operators’ entry into the broadband telecommunications field is due in no small part to the regulatory flexibility they are afforded under Title VI of the federal Communications Act in sharp contrast to the complex and somewhat uncertain situation faced by the incumbent telephone companies under Title II. Proposals to divide the incumbent into structurally separate wholesale and retail companies as a means to ensure fair access to the narrowband twisted wire pair infrastructure only will serve to ensure that incentives for broadband infrastructures operated by telephone companies are severely reduced. Consumers will be forced to wait until cable companies provide Internet access and other new services without the benefits of competition from the incumbent telephone company.

Deployment of broadband infrastructure by telephone companies, particularly in the form of Digital Subscriber Line (DSL) technologies, requires significant investments. Although the present discussion revolves around Asymmetric Digital Subscriber Line operating at data rates in the 128 kb/s to 1.5 Mb/s range, other technologies including High Speed Digital Subscriber Line, Rate Adaptive Digital Subscriber Line and Very High Speed Digital Subscriber Line (HDSL, RADSL and VDSL respectively) are commercially available. These technologies, generically referred to as xDSL, will allow subscribers to receive a multitude of new Internet based high bandwidth services over twisted wire pairs; but only if incumbent carriers have the incentives to upgrade their networks and deploy such equipment.

The existing twisted wire pair infrastructure was built to provide analog voice and limited circuit switched data services, with the majority of subscribers being served directly from the telephone company central office. In fact, the FCC estimates that over two-thirds of local loops employ copper wire pairs from the central office to the customer.39 Given that average loop lengths in the US exceed 7,000 ft, with well over 20% of the loops being longer than 10,000 ft and over 50% being longer than 5,000 ft, delivery of high speed data and other broadband services to the majority of Americans requires extensive conditioning of the existing twisted wire pair plant at best, but is more likely to require a massive build-out of fiber optic facilities.40

Deployment of xDSL services, even at relatively low data rates, requires additional equipment and build-out of the plant with fiber optics and new terminals to reduce the distance between the transmitting equipment and the residence or small business. Because of the heavy additional costs imposed by structural separation and continued regulation of the rates and other terms and conditions of the wholesale services, the wholesale company’s incentives to upgrade the network and evolve the narrowband infrastructure into a broadband infrastructure are significantly lessened. Timely deployment of broadband services requires that the investment community remain convinced that investments in infrastructure can be recovered through the exponentially growing revenues from new Internet-related services.

AT&T’s acquisition of TCI and the subsequent investments in infrastructure to provide high-speed Internet access and telephone services indicates that competition in broadband telecommunications is beginning to occur. The promise of competition is arising most strongly from cable operators entering the broadband field by providing high-speed data services over cable networks. These services, provided on a bundled basis which include cable modems and Internet access through an affiliated Internet Service Provider (ISP), are an attractive source of revenue for cable operators, and a welcome source of high-speed Internet access to consumers.

To some extent competition is beginning to occur on the telephone side of the fence as entrants gain access to twisted wire pairs to provide data services to businesses and residences. However, the existing twisted wire pair infrastructure is in no way adequate to carry broadband services at high penetration rates, and it will certainly not allow telephone companies to compete with cable operators in the provisioning of video services.

The vision of a competitive environment for telecommunications services – one in which competition occurs in the areas of traditional telephone services, Internet access, and video services – will only be realized if there are alternate infrastructures capable of carrying the full range of broadband services. Cable operators, able to provide broadband services without price regulation, unbundling, interconnection, or customer premises equipment concerns, are upgrading their networks. In contrast, incumbent telephone companies, subject to the complex and ever-changing Title II unbundling, interconnection, and resale requirements, have much less incentive to upgrade networks in order to enter into new businesses for which the prospects are uncertain. Proposals such as those of the Pennsylvania commission’s, which impose costs even greater than those which already are imposed by the existing safeguards regime, have even more deleterious effects.

There are two requirements for deploying advanced data and video services over twisted wire pairs: i} additional equipment needs to be deployed to support the new services, because the existing Public Switched Telecommunications Network (PSTN) infrastructure was not designed to support multi-megabit Internet access or video services; and ii} loop lengths need to be reduced to achieve multi-megabit transmission rates over twisted wire pairs.

The telephone industry in general and manufacturers of modems in particular have made tremendous progress in developing devices and systems which can achieve high data transmission rates over twisted wire pairs. The technological progress in this field appears somewhat akin to "Moore’s Law," which correctly predicted the evolution in the density of semiconductor devices as doubling approximately every 2 years. Modem technology appears to have made similar progress, with the data rates supported over twisted wire pairs doubling every 1.9 years.41 Nevertheless, increases in the bandwidth supplied to residential customers and small businesses are not being obtained merely by advances in signal processing algorithms and integrated circuit design. They are being achieved due to the build-out of the plant, typically by the laying of fiber optic cables and deployment of data service terminals in the serving area between the central office and the residence.

The relatively low data rates supported by today’s DSL – frequently limited to ISDN type rates for long loops – pales in comparison to the 25-50 Mb/s which can be supported using presently available VDSL technology on loops not exceeding 3,000 ft. Given that twisted wire pair has a limited – and very length dependent – data-carrying capacity, reducing the distance between the central office and the subscriber is critical in enabling the plant for broadband services.

Figure 1 illustrates how ADSL can be deployed from the telephone central office. Additional equipment, in the form of a Digital Subscriber Line Access Multiplexer (DSLAM) with appropriate ADSL modems, is required to modulate the data signal onto the twisted wire pairs. A diplexer is also required to combine the voice signal with the data signal. A POTs separation filter is used at the subscriber side to separate the voice signal from the data signal.

Providing data services over twisted wire pairs clearly requires additional equipment beyond what is in place today for narrowband services. More importantly, the number of subscribers that can be served by ADSL equipment directly from the central office is limited due to the loop length. Additionally, loops which do not exceed the maximum length for DSL service may have bridged taps or other impediments to digital data services. Achieving high penetration rates and providing data at above 1.5 Mb/s can only be accomplished by upgrading the telephone infrastructure and reducing the mean distance between the modems and the residence.

Figure 1: Deployment of ADSL from the central office

Figure 2 illustrates the deployment of DSL services from a location remote from the central office. In this example, voice services are provided from a remote terminal, which places the POTs cards closer to the subscribers, eliminating the need for large bundles of twisted wire pairs from the central office. This architecture, entitled Digital Loop Carrier (DLC), has been in place for narrowband services for many years, and in many scenarios is a cost-effective solution for providing voice services. Nevertheless, today’s DLC equipment does not support high-speed data services, and as illustrated in Figure 2, additional equipment including a remote DSLAM with ADSL modems needs to be deployed. At the central office, packet multiplexing equipment is required, and fiber must be utilized to interconnect the data multiplexer with the remote DSLAM. Clearly, the infrastructure in place for narrowband services, even when equipment is remotely located from the central office, does not support advanced data services without additional investment.

In addition to the fact that the amount of fiber used in the local loop is small, as evidenced by the fact that the vast majority of subscribers are served directly from the central office, fiber is only utilized in situations when the loop length is so long that it is a burden for traditional telecommunications services. As a result, local loop deployments of fiber reduce excessive loop lengths, but do not necessarily provide the basis for DSL services. In the case of Bell Atlantic, data from the FCC on Fiber to the Pedestal deployments42 indicates that the average loop length (fiber and copper) where fiber is deployed in Bell Atlantic territory is over 15,000 ft. As one would expect, Bell Atlantic deploys fiber not to reduce the average copper loop length to be able to support advanced DSL services, but rather because it is cost-effective for narrowband services. The fiber technology used may support a range of analog voice services, but there is no guarantee that any types of DSL services can be supported based on the existing equipment, or that the loop lengths have been reduced to the extent that multi-megabit per second data rates can be supported.

Figure 2: Deployment of ADSL from a remote terminal/DSLAM.

Figure 3 illustrates the deployment of an integrated Next Generation Digital Loop Carrier (NGDLC) narrowband/broadband infrastructure, based on combining packet- based Internet and video services with narrowband services. In this architecture, services are combined at the central office at a Broadband Digital Terminal (BDT) and transmitted over a fiber optic cable to a Universal Service Access Multiplexer (USAM) which is located within 3,000 ft. of the residence or business. Such equipment is commercially available, but the decision to deploy an advanced infrastructure is wholly dependent on the ability to recover the investment by providing new services. It is important to note that on the cable side, integrated architectures form the basis for new services, and cable operators are actively upgrading the HFC network to support both data and telephony services in addition to video.

Previous cost studies have demonstrated that all architectures: Fiber-to-the-Curb, Hybrid Fiber Coax, and Digital Loop Carrier, require significant investments to achieve high data rates at high penetrations.43 As an example, simple twisted wire pair loops have first installed costs on the order of $600 per subscriber, while Digital Loop Carrier and Fiber-to-the-Curb infrastructures can cost several hundred dollars more. The decision to deploy advanced infrastructure clearly depends on the business case that can be written for the use of the infrastructure.

In addition, the HFC networks owned by cable operators can be upgraded incrementally, while investments in switched infrastructures are more lumpy in nature. Cable operators, while unable to escape the fact that high bandwidth services at high penetration rates will require extensive infrastructure build-out, can enter the broadband telecommunications market gradually and relatively unhindered by regulation, choosing to serve the areas most likely to provide solid revenue streams. Telephone companies, faced with the decision to invest in fiber build-outs for future services, logically cannot choose to move forward on broadband services when regulation prohibits recovery of the investment on new services. Excessive regulation – such as the mandating of structural separation for infrastructure and services – only serves to deter the investments in the switched infrastructure which will be required to increase the data-carrying capability of the network.

Figure 3: Deployment of an integrated voice/video/data platform.

2. Separation of wholesale/retail operations will only serve to decrease investments in broadband infrastructures

Plans to create wholesale/retail operations for telephone infrastructure and retail services likely will have a chilling effect on the deployment of infrastructure for broadband services. Given the migration which will occur from narrowband circuit switched services to broadband services in the coming years, a phenomena already clearly taking place in today’s transitional marketplace,44 steps which create barriers to the deployment of infrastructure will only serve to decrease competition in telecommunications in the future and will prevent consumers from receiving new services at competitive prices.

In Pennsylvania, as elsewhere, delivery of xDSL services will require substantial investment on the part of Bell Atlantic. In order to compete in the video arena, very large investments would be required to reduce the loop lengths to under 3,000 feet, a length which would provide consumers with a source of switched digital services at video carrying rates. In an appropriately deregulated environment, Bell would make investment decisions based on the ability to provide new services free from unbundling requirements and pricing controls.

The Commission takes a different view of the investment decision, stating:

In contrast, BA-PA indicated that its DSL service offering is limited to customers served by relatively short loops that require no conditioning. This testimony indicates that BA-PA has no intention of serving a significant portion of the Pennsylvania market – the portion that is not presently served by an "ideal" loop, including loops over 12,000 feet. We cannot permit BA-PA to deny these customers the substantial benefits of DSL from CLECs simply because BA-PA has made the strategic decision to ignore this substantial market segment.45

The Commission fails to recognize that this "strategic decision" is related to Bell’s ability (or not) to recover its investment in the tremendous infrastructure build-out required to support services like ADSL. If there is insufficient incentive for the incumbent to roll out services like ADSL to a majority of customers, the situation for services like VDSL will be substantially worse.

The PUC’s structural separation proposal will only achieve further erosion of Bell’s incentives to deploy broadband-ready platforms. It indicates that not only do state regulators intend to continue regulating the narrowband infrastructure, but also that they intend to micromanage the transition to a broadband environment, determining specifically what upgrades are appropriate and when. Given the view widely that has been accepted in recent years that regulation should be reduced commensurate with the introduction of competition, certainly this would be a backwards step.

G. CONCLUSION

The Pennsylvania PUC proposal to require Bell Atlantic to establish separate corporate entities for its "wholesale" and "retail" local exchange operations is ill-conceived, even if well-intentioned. A decision to impose any new form of structural separation at this late date is questionable from a cost/benefit perspective. Before concrete steps were taken by federal and state policymakers to foster the development of a competitive local services environment, the costs imposed by structural separation may have weighed in the balance differently. But in an increasingly competitive local services environment, the Pennsylvania commission’s approach requiring the incumbent to incur the substantial extra costs associated with structural separation over and above the costs which would be imposed by nonstructural separation is harmful to consumers and, ultimately, to competition.

Most importantly of all, the Pennsylvania approach is unsound because it assumes, incorrectly, that competition in the local exchange is unlikely to develop in the foreseeable future. In fact, the Pennsylvania approach may become self-fulfilling because it will diminish the incentives for competitors, whether they be cable operators, CLECs, wireless operators, satellite services providers or others, to not build-out competing local network exchange infrastructures. By subjecting the incumbent telephone company’s local infrastructure to traditional regulatory controls for the indefinite future, the transition to a world of competing broadband facilities-based infrastructures will be slowed. This was not the vision of Congress in 1996 when it enacted the Telecommunications Act and it should not be the vision of Pennsylvania as we enter the next millennium.

ENDNOTES

* Jeffrey A. Eisenach is President and Co-Founder of The Progress & Freedom Foundation. Randolph J. May is Senior Fellow and Director of Communications Policy Studies at The Progress & Freedom Foundation. Charles Eldering is Senior Fellow at The Progress & Freedom Foundation and President of Telecom Partners, Ltd.

1. Telecommunications Act of 1996, Pub. L. No. 104-104.

2. "Consumer Choice Through Competition," Remarks by William E. Kennard, Chairman, FCC, at the National Association of Telecommunications Officers and Advisors, 19th Annual Conference, Atlanta, GA, September 17, 1999, at 5.

3. Id.

4. For the most recent action in the Local Competition proceeding concerning the unbundling of the ILECs’ local networks, see the Third Report and Order and Fourth Notice of Proposed Rulemaking, Implementation of the Local Competition Provisions of the Telecommunications Act of 1996, CC Docket No. 96-98, FCC 99-238, released November 5, 1999.

7. For a discussion of the need for a "containment policy" in which, at a minimum, broadband services are left unregulated even while narrowband services continue to be subject to traditional regulation, see Comments of the Progress and Freedom Foundation, Inquiry concerning the Deployment of Advanced Telecommunications Capability, CC Docket No. 98-146, filed with the FCC on Sepatember 14, 1998; also see Donald w. McClellan, "A Containment Policy for Protecting the Internet from Regulation: The Bandwidth Imperative," Progress on Point, August 1, 1997.

8. September 30 Order, at 215-235.

9. Apparently, no other state commission has ordered an involuntary breakup on this wholesale/retail basis, although the Massachusetts commission is presently considering this option.

10. September 30 Order, at 186.

11. Apart from the merits of the PUC’s decision, the way in which the settlement process was handled may have a chilling effect on the prospects for settlement negotiations in the future. In this instance, it appears that parties were invited to engage in voluntary settlement negotiations in an attempt to resolve on a global basis specifically-identified outstanding proceedings. The issue of the breakup of Bell Atantic along wholesale/retail lines was not specifically at issue in any of the underlying proceedings. By imposing such a drastic remedy in the context of what began as voluntary settlement negotiations, the commission makes it less likely that parties will be willing in good faith to enter into such voluntary negotiations in the future.

12. Bell Atlantic claims that its preliminary estimates show that it will incur expenditures in the range of $1 billion to complete the tasks necessary to comply with the PUC’s structural separation requirement. See Affidavit of Daniel J. Whelan, President and CEO of Bell Atlantic of Pennsylvania, Inc., p 4,, attached to Bell Atlantic’s Application for Extraordinary Relief, filed in the Supreme Court of Pennsylvania, October 21, 1999. While the authors of this report have not attempted to verify the accuracy of that claim, it is clear that the costs imposed on Bell Atlantic will be substantial.

15. For an extended discussion of the costs and efficiency losses attributable to structural separation, see the FCC’s discussion in its Third Computer Inquiry. Amendment od section 64.702 of the Comimission’s Rules and Regulations (Computer III), 104 F.C.C. 2d 958 (1986), at paras. 46-99. In that order, the Commission decided to eliminate the structural separation requirement on AT&T and the BOCs that it had imposed in Computer II because "the record strongly supports a finding that the ineffiencies and other costs to the public associated with structural separation significantly outweigh the corresponding benefits." Id., at para. 46.

16. Investigation to Establish Standards and Safeguards for Competittive Services, with Particular Emphasis in the Areas of Cost Allocations, Cost Studies, Unbundling, and Imputation; and to Consider Generic Issues for Future Rulemaking, Opinion and Order, docket No. M- 00940587, released July 18, 1996 (hereinafter "Competitive Safeguards").

17. Id., at 186.

18. Id.

19. September 30 Order, at 231. (Emphasis supplied.)

20. As pointed out earlier, if these non-structural safeguards are carried too far, their costs may exceed their benefits as well. For an instructive commentary on the costs of imposing excessive unbundling obligations, see Justice Breyer’s concurring opinion in AT&T V. Iowa Utilities Board, 119 S. Ct. 721 , 753-754 (1999). After explaining that the costs of excessive unbundling will discourage the incumbent from undertaking the investment necessary produce technological innovation, he summed up: "A totally unbundled world – a world in which competitors share share every part of an incumbent’s existing system, including, say, billing, advertising, sales staff, and work force (and in which regulators set all unbundling charges) – is a world in which competitors would have little, if anything, to compete about." Id., at 754.

23. Even a casual perusal of the merger application filed recently by MCI and Sprint makes clear that these parties now believe that local competition is near. They say: "With the advent of facilities-based competition for the provision of local telephone service, the separation of the provision of local and long distance services mandated by the Bell System divestiture will be erased. Competitors will be able to choose from a competitve array of local telecommunication products from a variety of suppliers, including and end-to-end voice and data service." Application of Sprint Corporation and MCI Worldcom, Inc. for Consent to Transfer Control, November 17, 1999, at 9.

24. Id.

25. If Bell Atlantic does not, in fact, meet the competitive checklist requirements, then the PUC would not recommend, nor would the FCC approve, a request by Bell Atlantic pusuant to Section 271, 47 U.S.C. §271, to obtain long distance authority.

26. September 30 order, at 234. (Emphasis supplied.) The Commission also refers to the need to conduct "operations studies" as part of the implementation proceeding. Id., at 233.

27. The Commission’s earlier Competitive Safeguards proceeding is instructive with regard to the likely length of such a proceeding. Even though strctural separation was not ordered in that proceeding, so that the Commission did not have to deal with the separation implementation issues it is now proposing to decide, the proceeding still took two years to complete. See Competitive Safeguards, at 2-11, for a description of the history of the proceeding.

28. 47 U.S.C. §272 (f).

29. 47 U.S.C §251(c)(4). (Emphasis supplied).

30. 66 Pa. C. S. $ 3005(h).

31. A separation based on "wholesale" versus "retail," as a practical matter, seems to place control over the characterization of the services in the hands of the customer based on the customer’s self-identification as either a "carrier" or "end user." Of course, major telecommunications "end users" such as large corporations often resell services, thereby putting themselves in the same position as "carriers," whether or not they are officially denominated as such. Therefore, this type of dichotomy, subject to regulatory gamesmanship by customers who may also be competitors even though not classified as "carriers," is not as workable as a regime in which the legislator or regulator designates certain specific services as "competitive."

32. Alfred Kahn, supra note 11, at 48.

33. 47 U.S.C. §251(c)(4).

34. For example, in recent testimony before the Senate Judiciary Committee in support of MCI’s proposed merger with Sprint, Sprint Chairman and CEO William T. Esrey stated that the merger better positions the companies "to compete in the bundled services marketplace." TR Daily, November 4, 1999. The merger application itself states that "[t]he familiar categories of local and long distance services are fading, as carriers offer local and long distance packages (soon to be joined by the BOCs) to meet customer demand, as long distance costs and prices continue to fall, and as wireless telephony growth explodes." Application of Sprint Corporation and MCI Worldcom, Inc. for Consent to Transfer Control, November 17, 1999, at 2. And AT&T just announced on December 1 that it plans to use Bell Atlantic’s platform of unbundled network elements to expand its rollout of local exchange services throughout New York. It is offering a "Local One Rate New York" plan which bundles local and long distance service. TR Daily, December 1, 1999.

35. 66 Pa. C.S. §§ 3001-3009. The statute defines "broadband" as a "communication channel using any technology and having bandwidth equal to or greater than 1.544 megabits per second." 66 Pa. C.S. §3002.

36. See Section 706(a)(1) of the Telecommunications Act of 1996, codified at 47 U.S.C 157 nt, which provides that the FCC and each state commission shall encourage the deployment of "advanced ,telecommunications capability" to all Americans. Section 706 (c) (1) defines advanced telecommunications services, without regard to the transmission media or technology, as "high-speed, switched, broadband telecommunications capability that enables users to originate and receive high-quality voice, data, graphics, and video telecommunications using any technology." 47 U.S.C. 157 nt.

37. See also Comments of the Progress and Freedom Foundation, Inquiry Concerning the Deployment of Advanced Telecommunications Capability, FCC Docket No. 98-146, filed with the FCC on September 14, 1998, for a full discussion concerning how, at a minimum, broadband services should be protected from regulation.

38. There are other broadband services that already do compete, or are capable fairly soon of competing, with cable modems and DSL services. The FCC recently stated that: "Actual or potential providers of broadband services may include: LECs (incumbent and competitive, both resale and facilities-based, regardless of the technology used), cable television companies, utilities, MMDS/MDS/’wireless cable’ carriers, mobile wireless carriers (both terrestrial and satellite-based), fixed wireless providers, and others." Local Competition Broadband Reporting, Notice of Proposed Rulemaking, CC Docket No. 99-301, released October 22, 1999, at para. 32. Indeed, the FCC recently reaffirmed that , in light of the deployment of cable modems and other broadband technologies, "the incumbent LEC does not retain a monopoly position in the advanced services market." Local Competition Provisions of the Telecommunications Act of 1996, Third Report and Order and Fourth Further Notice of Proposed Rulemaking, CC Docket No. 96-98, released November 5, 1999, at para. 308.

44. See Deployment of Wireline Services Offering Advanced Telecommunications Capability, CC Docket No. 98-147, FCC-147, released December 9, 1999, at para. 8, whereC states: "In the near future, xDSL-based technology and pocket-switched networker may account for a large portion of the telecommunications facility."

45. Opinion and Order of the Pennsylvania Public Utility Commission on Dockets P-00991648 and P-00991649, August 26, 1999, p.112